13-0 Systematic Risk 13.4 Risk factors that affect a large number of assets Also known as non-diversifiable risk or market risk Includes such things as changes in GDP, inflation, interest rates, etc. LO3 © 2013 McGraw-Hill Ryerson Limited
13-1 Unsystematic Risk Risk factors that affect a limited number of assets Also known as unique risk and asset- specific risk Includes such things as labor strikes, shortages, etc. LO3 © 2013 McGraw-Hill Ryerson Limited
13-2 Returns Total Return = expected return + unexpected return Unexpected return = systematic portion + unsystematic portion Therefore, total return can be expressed as follows: Total Return = expected return + systematic portion + unsystematic portion LO3 © 2013 McGraw-Hill Ryerson Limited
13-3 The Principle of Diversification Diversification can substantially reduce the variability of returns without an equivalent reduction in expected returns This reduction in risk arises because worse than expected returns from one asset are offset by better than expected returns from another However, there is a minimum level of risk that cannot be diversified away and that is the systematic portion LO2 & LO3 © 2013 McGraw-Hill Ryerson Limited
13-4 Figure 13.6 – Portfolio Diversification LO2 & LO3 © 2013 McGraw-Hill Ryerson Limited
13-5 Diversifiable (Unsystematic) Risk The risk that can be eliminated by combining assets into a portfolio Synonymous with unsystematic, unique or asset-specific risk If we hold only one asset, or assets in the same industry, then we are exposing ourselves to risk that we could diversify away The market will not compensate investors for assuming unnecessary risk LO3 © 2013 McGraw-Hill Ryerson Limited
13-6 Total Risk Total risk = systematic risk + unsystematic risk The standard deviation of returns is a measure of total risk For well diversified portfolios, unsystematic risk is very small Consequently, the total risk for a diversified portfolio is essentially equivalent to the systematic risk LO3 © 2013 McGraw-Hill Ryerson Limited
13-7 Systematic Risk Principle 13.6 There is a reward for bearing risk There is not a reward for bearing risk unnecessarily The expected return on a risky asset depends only on that asset’s systematic risk since unsystematic risk can be diversified away LO3 © 2013 McGraw-Hill Ryerson Limited
13-8 Measuring Systematic Risk How do we measure systematic risk? We use the beta coefficient to measure systematic risk What does beta tell us? A beta of 1 implies the asset has the same systematic risk as the overall market A beta < 1 implies the asset has less systematic risk than the overall market A beta > 1 implies the asset has more systematic risk than the overall market LO3 © 2013 McGraw-Hill Ryerson Limited
13-9 Figure 13.7 – High and Low Betas LO3 © 2013 McGraw-Hill Ryerson Limited
13-10 Table – Beta Coefficients for Selected Companies LO3 INSERT NEW TABLE HERE © 2013 McGraw-Hill Ryerson Limited
13-11 Total versus Systematic Risk Consider the following information: Standard DeviationBeta Security C20% 1.25 Security K30% 0.95 Which security has more total risk? Which security has more systematic risk? Which security should have the higher expected return? LO3 © 2013 McGraw-Hill Ryerson Limited
13-12 Example: Portfolio Betas Consider the previous example with the following four securities SecurityWeightBeta ABC DEF GHI JKL What is the portfolio beta?.133(3.69) +.2(.64) +.267(1.64) +.4(1.79) = LO3 © 2013 McGraw-Hill Ryerson Limited
13-13 Beta and the Risk Premium 13.7 Remember that the risk premium = expected return – risk-free rate The higher the beta, the greater the risk premium should be Can we define the relationship between the risk premium and beta so that we can estimate the expected return? YES! LO3 © 2013 McGraw-Hill Ryerson Limited